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Credit Default Swap

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A credit default swap is a credit derivative. A credit default swap is also called CDS. A credit default swap is similar to an insurance contract in that it transfers credit risk associated with a transaction or investment product from the purchaser of such credit default swap to the seller of the credit default swap. Under the terms of a credit default swap contract, the seller agrees to bear the credit risk of a counterparty or an investment product in exchange for premium payments by the buyer of the credit default swap. In the event a credit event is triggered (i.e. bankruptcy, payment default), the seller of the credit default swap will have to compensate the buyer of such credit default swap in accordance with the terms of the credit default swap contract. For example, during a cash settlement of a credit default swap, the seller will pay the buyer of the credit default swap the difference between the market value and the par value of the investment product. Credit default swaps are sold over the counter. Credit default swaps are not regulated so there is added risks that the seller will not perform if a credit event is triggered. While credit default swap trades can be resold on the open market multiple times, there is no oversight to guarantee that in the end, the credit default swap seller will be able to pay up if a credit event is triggered. Credit default swap contracts have been under a lot of scrutiny as a result of the financial events that started with the US subprime loan crisis in 2007 and ultimately resulted in the bankruptcy, buy-out and government take over of many major financial institutions (i.e. Bear Sterns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers)



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